In mid-2014, Towers Watson launched its “Principles and Elements of Effective Executive Compensation Design,” a compendium of research, insights and viewpoints about effective executive compensation (EC). The Principles serve as a counterpoint to the familiar mantra of “following market norms” and the often narrower perspectives of proxy advisors and pay commentators (and even some pay consultants).
In parallel, we launched an assessment framework to support the ongoing management of executive pay programs. This tool allows companies and their compensation committees to evaluate how closely their programs align with the Principles. More importantly, the framework helps to ensure that pay programs are carefully tailored to a company’s business strategy, even where that means varying from the market or even the Principles themselves.
Since the launch, we’ve had in-depth discussions with hundreds of companies and have used the tool in approximately 75 in-depth EC program reviews. Below, we highlight some of the initial findings from the assessments. We believe they offer important insights about the future direction of EC design.
Before jumping to the findings, here’s a quick recap of the Principles and the framework. The 75 Principles cover the gamut of critical EC considerations: from peer group selection and benchmarking to incentive design and pay-for-performance assessment, from governance to employment terms and special circumstances (e.g., M&A, retention, new hires and exits). The framework helps companies systematically assess their EC programs and processes, indicating areas where a company is tracking with the Principles (“alignment or high alignment”) or varying from them (“low alignment”).
AREAS IN WHICH EC PROGRAMS ARE PROVING EFFECTIVE
Based on the assessment tool results to date, the two categories of EC programs most aligned with the Principles are peer groups and benchmarking, and EC governance. For those who track EC developments, this isn’t a big surprise. Peer group selection has been under the microscope for several years and many companies have worked hard to develop a sensible and generally robust approach to benchmarking. There’s still work to be done in certain aspects of benchmarking, such as considering total rewards versus only direct compensation, and thinking of market data as a range instead of a single data point (e.g., the 50th percentile). But on the whole, most companies are aligned.
Moving to governance, especially in the say-on-pay environment, compensation committees are generally approaching their roles with vigor and increasing expertise. In parallel, pay disclosure has become more transparent and shareholder engagement more regular. Again, while overall alignment is strong, the Principles highlight specific items for focus, especially around the committee’s role in promoting the transparency and rigor of pay-for-performance relationships.
PRIORITY AREAS FOR IMPROVEMENT
The two categories with the lowest levels of alignment are pay-for-performance (P4P) assessment and incentive targets, ranges and discretion.
The disclosure of P4P is definitely on everyone’s radar screen as we await Securities and Exchange Commission (SEC) guidance on the Dodd-Frank disclosure requirements. However, disclosure aside, the breadth of many companies’ P4P assessments appears rather limited in terms of pay definitions, performance measures and regularity. Moreover, the results indicate that few companies are leveraging P4P analyses to test if they are getting the downside of pay “right” (i.e., ensuring pay outcomes track with performance when performance weakens). We know that the combination of weak company performance and poor P4P alignment is very likely to trigger shareholder and proxy advisor concerns. The Principles’ focus on enhanced P4P assessment points the way to improved pay design and mitigating say-on-pay risks.
Incentive vehicles and performance measures receive significant attention from executives, committees and investors alike. But this focus appears to weaken, at least based on our assessments, when companies endeavor to set robust incentive targets and ranges, and to apply informed judgment on incentive payouts. Admittedly, target and range setting and discretion are challenging areas for management and committees alike. However, it appears that they aren’t using many of the tools in their potential toolkit to tackle these issues more directly. Some of these tools include analytics around historical company and peer group financial performance as well as shareholder expectations, referencing so-called enduring standards around growth and returns in setting targets and applying a “discretion framework” to assess if and how discretion should be applied to incentives.
FUTURE DIRECTION
One might suggest that the Principles may be too aspirational or impractical, especially in these areas of P4P assessment and incentive targets, ranges and discretion. The assessment results suggest otherwise. As for P4P assessment, roughly a third of the companies in our database achieved overall standards of “alignment” or “high alignment.” For incentives, about 45% of the companies in our assessment database achieved these standards. They are clearly within reach.
While we don’t have longitudinal data, our experience shows that standards in these areas have evolved over the past several years. The companies that are aligned with our Principles are at the forefront of the market and are pointing us to the future. This is a future where robust and holistic P4P assessment is going to be the norm (likely beyond what’s required for proxy disclosure by the SEC), incentive targets and ranges are going to receive greater scrutiny from shareholders and directors, and more companies and directors are going to be comfortable applying informed discretion to balance the heavy financial and formulaic orientation of incentive plans.
The assessment results also highlight somewhat narrower topics that may attract greater focus in the future. Among these are:
– Promoting greater line of sight and shareholder alignment in incentive programs
– Scaling share ownership guidelines to equity compensation levels
– Strengthening share retention and holding requirements.
Overall, we know that EC will continue to evolve, much as it has over the past two decades. Through the lens of our Principles and systematic EC program assessment, companies can chart their own course, while also being informed by the experience of their peers.
